Investing, Asset Allocation, Economics & the Search for the Bottom Line

A Precarious Optimism

The euro crisis is no garden variety hazard for the financial system, or even the global economy, but market sentiment in the U.S. seems to be holding up quite well in the face of the latest round of the ill winds via Italy.Yesterday’s rally in stocks is one inspiring data point. Another is the staying power of inflation expectations via the yield spread on the 10-year Treasury less its inflation-indexed counterpart. It could all evaporate in the twinkling of an eye, but for now there’s a view that the glass is still half full in these United States.

This inflation forecast, when it falls precipitously for a stretch, has been an early warning sign of trouble in recent years. Disinflation/deflation is the enemy in the current climate and so this Treasury metric is one way to evaluate the slippery concept of pricing expectations. The fact that the implied Treasury outlook on inflation is holding steady offers a glimmer of hope that the Italian edition of the euro disaster won’t bite the U.S. Or perhaps it’s safer to say that the crowd is currently anticipating that the bite will only be skin deep.
The guidebook here is that the abnormal connection of late between inflation expectations and the stock market suggests that falling inflation expectations are a harbinger of darkness. Accordingly, the ability of the Treasury market’s to hold the line at 2%-plus in recent days is encouraging, albeit in a close-to-the-edge-anything-could-happen-tomorrow sort of way.
It doesn’t hurt that the St. Louis Fed’s Financial Stress Index has fallen modestly this month, or that yesterday’s encouraging update on initial jobless claims suggests that the labor market is standing tough too.
But any optimism is a precarious creature these days, subject to adjustment on the news from the next economic report. I may be going out on a limb here, but it’s hard to imagine that the crowd has much tolerance for disappointment. Anxiety over Europe (and perhaps even China) suggests that the margin for error is virtually nil. More than ever, the U.S. economic updates must avoid disappointment. That’s a high hurdle. But for the moment, the crowd seems to hold out the hope that America can continue to struggle forward.